Isn’t quantitative easing a wonderful thing? Asset values surge on the back of easy money, whatever the outlook for the economies and companies. Scribblers rush to write that markets are rising because there is a profits improvement, or in desperation turn to the charts and say it is all because the chart patterns look good. Of course the charts look good – easy money is pushing up share and commodity prices. Profits are benefitting from the tough cost control action many US and UK companies have taken. Top lines are not doing well, as activity remains very flat. As we hoped, the emerging markets and Asia are rallying more strongly than the West, as their growth story is better.
Ahead lies a modest recovery in the West, which will look better on some figures if only because last year’s comparisons are so dire. Also ahead lies the need at some point to stop money printing, and to recognise the need for action to tackle government debt. Last quarter’s GDP figures in the US were helped by strong public spending. The UK has still to take proper action to cut government costs. The UK is likely to run a loose policy right up to the election, whilst President Obama already seems to be thinking of delay in facing reality for the second term if only he can get there as big spender. At the moment his attention is on trying to win the votes necessary to increase US state financed health bills. All this is better news for shares than for government bonds in both the US and the UK.
On 28th November last year we made our last positive recommendation to hold or buy UK gilts, when the 25 year yield was 3.8%. By early January gilt prices had risen and the yield had fallen to 3.1%. We issued the first of many warnings of the gilt bubble the government was creating, which we repeated at regular intervals in the first half of 2009. The yield on the 25 year bond has now risen as high 4.6%, with the consequent fall in the bond price compared to last November.
Has it now fallen enough to take full account of the negatives? I fear not. The prices of gilts of most maturities have fallen despite the large government buying programme to buy gilts. At some point the government buying will cease. There has also been large purchases by banks, required by the new rules demanding that they hold higher liquid balances, which they usually hold in gilts. This too will moderate as they reach their new regulatory targets. Interest rates are well above the notional 0.5% level set by the Monetary Policy Committee of the Bank of England. Banks are rebuilding margins by lending at much higher rates and fees. The interest rates on lending to the government have risen and are likely to rise further, as the full horrors of the public finances become apparent to more people. The authorities will try to run with low interest rates for a long time, but in practise rates are rising as the market dictates they should. Banks need to earn bigger returns, and banks are determined to charge more for the risk of lending to both the private and public sectors. The authorities are restricting the amount of private sector lending by their more demanding new rules on banks cash and capital, thereby limiting competition.
The biggest problem the market will face is the lack of any action plan to curb the deficit properly in future years. No UK political party has yet spelt out a programme of spending reductions that are up the task. No political party wants to talk about serious tax rises, and most are aware that some tax rises could make the problem worse if they drive business and enterprising people away from the UK. So we remain in a long pre-election period, when the public finances drift, and the problem gets worse. Whilst the fall in gilts has happened as we feared, we still do not think it right to buy them yet. The yields are better, but there is no shortage of supply in the months ahead. There’s no need to hurry whilst stocks last.